Friday, February 1, 2013

Mortality Credits and Period Certain

Mortality credits and period certain are two important concepts not to overlook when discussing the features of a life annuity product.  Many people aren’t familiar with these essential terms.   

Consider this: Doug and Helen walk into a bank. Doug is 20 years old and Helen is 70 years old. They both tell the bank officer that they have $100,000 to invest and want to take the most interest they can get for the rest of their lifetimes.

Because of her age, Helen has a distinct advantage in her number of choices.  Helen could simply put $100,000 in a bank CD and take the current interest rate of 2% on a five-year CD.

However, Helen also has the option of taking a life annuity1 or a life annuity with period certain2 instead of a CD.  A life annuity would pay her an income for as long as she’s alive.  A life annuity with period certain means that if she dies before a stated period (usually 20 years), payments would continue to be made to her heir(s) for the remainder of the stated period (in this case, we’ll use 20 years). 

Mortality credits play an important part in this decision. According to Annuity Digest3, mortality credits are also known as the mortality yield. Simply put, mortality credits are the reallocation of contributions of those who die to those who survive.  With a participating annuity, premiums paid by those who die earlier than expected contribute to gains of the overall pool and provide a higher yield or credit to survivors than could be achieved through individual investments outside of the pool. The mortality credit increases significantly with age and hedges longevity risk, often creating a return that would be impossible to match in the broader financial markets.  The older you are, and the longer you live, the more mortality credits you can get paid.

For example, let’s assume that out of 100 people that are 70 years old, 10 of them die in the next year. Those 10 people had contributed $100,000 or a grand total of $1 million (in addition to interest).  That $1 million is now divided among the 90 surviving people. So that $1 million goes above and beyond the interest that was paid. The 90 survivors will get $11,111.

Now, the question becomes, “what if you’re one of those unlucky 10 who pass away?” That’s where period certain comes in and can offset things. A life annuity with period certain simply states that your income will continue to be paid for as long as you and/or your spouse are living.  If you pass away before this period of time, your heirs will receive the income for the duration of the specified period certain.

In this illustration, we're using a $100,000 investment with a 20-year period certain.  If the product pays income of $5,600 a year, this means that in the worst-case scenario over the 20 years, the individual or their heir(s) would receive $112,000 back in payments.
As you can see, you do not want to overlook mortality credits and period certain when discussing the features of a life annuity product.  The mortality credit often creates a return that would be impossible to match in the broader financial markets.

To discuss your comprehensive financial plan or for more information, contact us today. 

"Life Annuity" Investopedia;

"Mortality Credit” Annuity Digest;

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